Yes, finance is different

I bang on and on here about the necessity of the rule of law. We cannot, if we are to retain any shred of liberty, be ruled by whims and opinions, it must be written down, in advance, what we may and may not do.

However, finance is different:

Giving evidence to the Treasury Select Committee, George Osborne argued that moving regulation into a single institution, the Bank of England, and allowing supervisors to apply their judgement would prevent a repeat of what he described as \”the biggest bank failure in the world\”.

Had the incoming regulatory regime been in place in 2007, he said, RBS would not have been allowed to push ahead with its £50bn ABN acquisition. Labelling the takeover \”a shocking failure of regulation\”, he added: \”After the bank run at Northern Rock, after the credit markets had frozen, the UK regulators allowed RBS to buy ABN Amro.

\”The reason they allowed the merger to take place is because there was nothing that RBS was doing wrong. It ticked every box. There didn\’t seem to be anyone saying, \’Hold on, are we going to allow RBS to buy this enormous Dutch bank?\’

\”What I\’m trying to do is get to a position where the Bank Governor exercises that kind of judgment… The awareness that this is not the moment when we\’re going to wave through huge takeovers.\”

Banking specifically: the liquidity risks of fractional reserve banking are such that it isn\’t possible to have that rules based, tick box approach. It is necessary for there to be, as best we can manage, those wise peeps who look over shoulders and tell people what they may not do.

In essence, taking out a banking licence means that one is giving up that right to a purely law based regulatory regime.

Carving out such exceptions is dangerous of course: as soon as I\’ve said that banking licences mean such there\’ll be someone else saying that of course this applies to commodities, credit cards,  ATMs and doorstep lenders. But none of those have that fatal flaw built in in the same way that fractional reseve banking does. All banks, by definition, are illiquid. As Brad DeLong says, if you borrow short and lend long you\’re a bank (and he goes on to point out that if you\’re not borrowing short and lending long then you\’re not a bank): and to extend his point, if you borrow short and lend long you\’re illiquid. Ergo, banks are illiquid by definition.

We could extend this argument a little: the rule of law is necessary except when it isn\’t. As markets are just wonderful, work perfectly, except when they don\’t. Knowing when they don\’t is very difficult in some cases, very easy in others. But making the distinction between when they do and when they don\’t is vital.

As an early morning musing we could try plotting political views perhaps, from libertarian through to Statist. I have a feeling that there would be a very large correlation between those arguing for markets, all the time markets, and rule of law, all the time law, through to those who might, just, allow that markets work well enough in delivering sweeties to kids and that the law has its place, well after the opinions of bureaucrats and politicians.

I being perhaps around the t or h of the \”through\” and Ritchie being somewhere beyond the full stop after the \”ist\”.

But I do think that there\’s a spectrum, almost all of us acknowledging exceptions to either markets or law. The differences being, with the law say, whether it\’s almost anything or those few and peculiar cases when the granting of a specific privilege (say, a banking licence) leads to rules and law not being sufficient.

So there\’s me taking my stance, right in the middle of a logical quicksand. Both the rule of law and markets have their time and place, it being my opinion as to which those are. Quite the point to base a political or economic philosophy on, isn\’t it?

9 thoughts on “Yes, finance is different”

  1. But it actually reveals a much more fundamental point: society must leave room for this sort of judgement, to allow the competition of varying ideas about how both the law and market should function. The extremist libertarian and socialist positions eliminate the scope for this competition in one way or another – libertarians by shutting down the scope for state intervention in the market, and socialists by shutting down the scope for private participation in the market.

    I think an awful lot of people could back a position which says society should leave the scope for this sort of judgement-forming debate as wide as possible. We could call it ‘liberalism’.

  2. Can we trust the BoE supervisors to be all knowing and wise, able to accurately predict these problems in advance? Can we be sure that they will not be corrupt, seeking to profit in some way by allowing bad deals to proceed or by preventing what would probably have been a good deal? Regulatory capture?

    If the liquidity risks of fractional reserve banking are such a problem (and I agree that they are), why not get rid of fractional reserve banking? Let bank deposits truely be deposits and let banks (or whatever other name we wish to call them) fund their loans by issuing corporate bonds. I believe that the delusion of FRB, that all of our deposit money is instantly available and that it is “safe”, is largely the cause of the problem. Remove this government backed delusion and the market will perform much better.

  3. The problem is, and this is the hardline libertarian view perhaps, well okay it is, that there is no possible system that can render this inherent illiquidity safe. Hoping for any regulatory regime that will do so is liking hoping for a justice system that never convicts the innocent and frees the guilty. It feels like it ought to be achievable, but it isn’t.

    It doesn’t matter whether you use a strongly codified “tick box” approach or an arbitrary, “non-law” based approach. It simply cannot be done.

    Now that doesn’t mean, as some libertarians argue, that one must outlaw FRB. In a genuinely free market, people will choose to create FR businesses so, ironically, to stop it you’d need intense State intervention, which is not libertarian. “Rothbard’s Paradox”.

    What you can do is expose these businesses fully to the markets and risk; and to make people aware that whenever they give their money to such a business, they are putting it at risk. Free markets are the best regulator there is.

    Two years ago (or was it three?, my time flies) the market, as “regulator”, tried to destroy these businesses, because they had acted very foolishly. We stopped it “regulating” them out of existence, and instead gave them lots of money and demanded they do the same again but, oh, be more careful next time. Which is like giving your scorched children another can of petrol and box of matches.

    What is wrong, deeply wrong, is the concept of banking as an “institution”. We have deliberately created economies that utterly depend on a vastly overbloated banking system, which lends too much money and thus moves in every boom cycle from lending wisely at the start to profligately and foolishly at the end. Take what brought the market down this time- mortgages. Anyone in a free market seeing that many people borrowing that much money just to get a roof over their head would recognise that there is some profound systemic problem.

    But not when you have this mindest of borrowing as the basis of economic growth. You get into this delusion that more and more borrowing is better and better, even when it being sunk into unproductive pure costs like housing. It is that mindset that has to change.

    There is certainly an important place for banking- including FR banking- in a free market. But it would look very little like what we have now under the Central Bank State Managed system; which is just a financial version of the Petrol And Matches Game and which cannot be “regulated” into safety, however you try to do so.

  4. The other point is that there seems to be a perception at least among some libertarians that you can solve all banking’s problems by banning FRB. In effect, that by not lending out demand deposits banks become stable. But that isn’t true. Even if they’re only lending time deposits, they can still lend them to people who can’t pay them back, and thus they can still fail. There’s no way around that problem, even if banning FRB would save us from the traditional “bank run”.

  5. if they’re only lending time deposits … they can still fail.

    Yes, the time deposit / lending banks (or part of banks) may fail. So what? So long as the demand deposits banks (or part of banks) and the underlying banking infrastructure (data centres, ATM network etc) are properly isolated from this failure, it doesn’t particularly matter if the lending part (of one bank or of every bank) fails.

  6. “there is no possible system that can render this inherent illiquidity safe”

    But it is easy to get rid of the inherent illiquidity in the first place.

    Tim *defines* banking as borrowing short and lending long (maturity transformation). This definition is silly, because it leaves institutions which borrow short and lend that money short, and borrow long and lend that money long, but are otherwise the same as current institutions, without a name.

    In the past Tim has repeated the canard that borrowing short and lending long creates value. It does not.

    What we want to do is to get rid of borrowing short and lending long.

    I’m not sure whether banks which borrow short and lend long could survive in a free market, or whether such activity would need to be banned. But my guess is the former: such institutions could not possibly survive in the free market. They would go bust all the time and few people would choose to keep their money with them, so they would be outcompeted by non-maturity transforming banks.

    Why aren’t there any non-maturity transforming banks in the UK? Because they are impossible to set up, because the courts refuse to enforce banking contracts between banks and depositors. If you set up a non-maturity transforming bank, and then decide to start borrowing short and lending long, and your depositors sue you, the courts will back you. Oops.

    This issue is one of Tim’s few failings, along with pensions.

  7. Loan brokerage is an inherently risky business. A bank which only loans timed deposites faces the same risk as a bank which lends demand deposits; that its borrowers may not be able to pay the money back. When a generic error occurs, as with mortgage over-lending, the system will fail. It may not fail as spectacularly and instantly without the demand deposits problem, but it will fail just as surely.

    Any loan broker runs the same risk. The only “safe” banking is a bank that is not a loan broker- that is, just keeps your gold in a safe. Once you start on loan brokerage, you run risk and, due to the madness of crowds problem, you will get systemic failures when all the loan brokers loaned too much of the money foolishly at the same time for the same reason.

    Take the simple fact that the mortgage business and property market are demonstrably, clearly stupid. But hardly anyone recognises this. People, and especially banks, think that the current state of property values is quite normal. Most of the population want property prices to rise faster than inflation, and actively support land usage restrictions to make that happen. They actually consider falling prices to be a disaster about which Something Must Be Done. Millions of people took out loans they could not afford due to the bizarre belief that a cost, housing, is an “investment”, and huge banking institutions loaned it to them due to the same comical delusion.

    You cannot have a stable system when the people using it and running it are that retarded. It’s that simple. And it’s why the system failed last time and is going to keep failing, whatever type of loans you allow, regulate, etc etc.

  8. Ian B, yes, all lending is risky. Getting rid of maturity transformation wouldn’t change this.

    But it would prevent bank runs, and would solve the problem of contagion because it would obviate interbank lending.

Leave a Reply

Your email address will not be published. Required fields are marked *